Investors Lose Out to Inflation Through Absolute Returns

(January 11, 2012)  —  A lack of oversight on the inflation exposure of a fund’s underlying assets often cancels outperformance promised by investment managers, a study has found.

There is a mismatch between what asset managers offering ‘absolute return’ funds cite as outperformance and what their institutional clients need and expect, Switzerland-based Blue Diamond Asset Management said – and it is costing investors dearly.

Despite most pension schemes and foundations stating their return objectives relative to inflation to match their liability streams, most investment managers target and report their investment performance for a variety of strategies in nominal terms, Blue Diamond said.

Absolute return funds were launched by hedge fund firms and other investment managers, offering investors positive returns whatever the economic conditions. However, many of these funds came unstuck in 2008 when very few could struggle against the general downward spiral of the market.

Hedge funds lost an average 4.8% last year, which was positive compared to a slump by the MSCI World Index of 7.61%. However, by the end of the year, in the United Kingdom inflation was running around 5%; in the United States inflation was running at around 3.4% and pushed up liabilities.

Even in more healthy market conditions, Blue Diamond’s study said that some managers were short-changing their investors by failing to recognise how inflation ate into returns derived from underlying assets.

The study said: “In any given period…even a commendable 3% absolute return during, for example, a -2% return in the equity market, will erode purchasing power if inflation is 4%.  Such “outperformance” could be devastating if similar periods of negative real returns repeat often enough.”

The study said investors should focus on fund managers and their products that offer ‘real returns’ and take into account the inflationary hit, especially in the current low-return environment.

The study said that liability-driven investors should consider those funds that maximised their real returns – having deducted the effect of inflation – throughout the portfolio building management process, rather than simply using an inflation hedge.

Furthermore, the study said: “Inflation-hedging strategies often base investment decisions on the historical correlation between inflation and high inflation beta assets. In certain circumstances, this correlation might not hold.”

It cited using real estate as an inflation hedge as it was highly correlated with inflation when property values continued to rise, but this relationship broke when the real estate bubble burst over the last decade.

It concluded: “The necessity to protect asset value from inflation erosion is real. The way to do that, and to also maximize real returns, is to shift to a paradigm that explicitly considers the appropriate inflation rate for underlying liabilities. The most forward-thinking investors and their managers are raising the bar by focusing not on excess relative returns or absolute returns, but positive real returns.”